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November 6, 2012

4 Post-Election Fiscal Cliff Scenarios

Investment and risk expert Reto Gallati warns that the fiscal cliff still poses a ‘significant and immediate challenge’ to America’s economic recovery

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It’s Election Day. If we’re lucky and the votes get tallied quickly and accurately, we’ll all know by Wednesday whether Barack Obama has won re-election or presidential contender Mitt Romney ran a victorious campaign. A day or so after that, we’ll know whether the Democrats or the Republicans have control of the U.S. Congress and Senate.

What we still won’t know, though, is whether the U.S. economy is still doomed to fall off the notorious “fiscal cliff” that economists and analysts have been warning about.

Gallati, formerly the chief risk officer and head of investments at Nuveen Investments and a former deputy chief risk officer at Putnam Investments, notes that the possible expiration of the Bush tax cuts and the sequestration process represents “a doomsday scenario” that can be averted only through significant efforts by Congress to reach a compromise during its lame-duck session before new leadership takes over in January 2013.

“Today we stand at the foothill of the cliff, which in our case is Capitol Hill,” said Gallati, now president and CIO of Raetia Investments, in a statement. “If we want to avoid what could be an extremely dire economic outcome, American needs our elected officials to demonstrate leadership. Without significant movement soon, our economy teeters at the edge of the precipice, poised to fall over the cliff if politicians in Washington fail to find a timely agreement.”

What will happen if our newly elected president and Congress fail to act? Read on to learn about the four potential fiscal cliff scenarios that Gallati believes might occur.

1) The Dreaded Lemming Scenario. In this worst-case scenario, says Gallati, Congress and the White House fail to reach an agreement and America’s economic recovery goes over the cliff.

Reflecting this view, Leon LaBrecque, founder and managing partner of registered investment advisor LJPR, a Troy, Mich., firm with $470 million in assets, warns that the fiscal cliff represents the biggest tax increase and/or spending cut in recorded history.

“The Bush tax cuts expire, the payroll tax holiday expires, the unemployment extension expires, the sequestration cuts kick in, new Affordable Care taxes kick in, and all at the stroke of midnight on Dec. 31,” writes LaBrecque in a comment. “Then, for good measure, the debt ceiling expires a month or two later. Taxes change dramatically. Income taxes go up for everyone who pays, and the estate tax rate soars while the credit drops from over $5 million to $1 million. It’s a colossal mess.”

2) Kick the Can. Congress and the President could kick the can down the road a bit by agreeing to punt the issue into 2013, according to Gallati. They would do this by signing a temporary measure in 2012 that allows the tax cuts to remain in effect for a temporary period.

“Tax increases would be averted and the spending cuts could be delayed until after the inauguration and a new Congress takes over in 2013,” Galati says.

3) A Modest Compromise. Under this scenario, Galati says Congress and the president would reach an agreement containing a combination of tax increases and spending cuts. In this instance, the core of the fiscal cliff will be avoided and the key issues of the budget cuts will be pushed further out.

While awaiting such a compromise, investors might want to prepare for the possibility of fiscal cliff-related volatility and economic weakness by adding or maintaining liquidity, particularly in tax-free securities like shorter-term municipal bonds, says Jerry Webman, chief economist at OppenheimerFunds.

4) A Grand Bargain. Under Galati’s best-case scenario, both political parties agree on a compromise that addresses fiscal issues, spending cuts and taxes.

“Avoiding the fiscal cliff will require a bipartisan compromise by both parties to allow the incoming president, whether it is Obama or Romney, to move forward,” Gallati says. “Once the uncertainty of this issue is removed, the market can refocus on fundamentals. Uncertainty will diminish and billions of dollars sitting on the sidelines could eventually come back to the financial markets.”

Gallati believes that a grand bargain is the optimal outcome for investors.

So do the CEOs of more than 80 major U.S. corporations—including the heads of BlackRock, Goldman Sachs and JPMorgan Chase—who came together in late October to urge Washington’s lawmakers to tackle the country’s fiscal woes.

"Policymakers should acknowledge that our growing debt is a serious threat to the economic well-being and security of the United States,” their statement reads. “It is urgent and essential that we put in place a plan to fix America's debt. An effective plan must stabilize the debt as a share of the economy, and put it on a downward path.”